Remember the old E.F. Hutton ads from the 1980s?  In a typical spot, a broker and his client are trying to have a private conversation in a bustling restaurant, but when the broker mentions the name, “E.F. Hutton,” the room goes silent as everyone strains to hear the wisdom that seems sure to follow.  The tag line for the long-since dissolved brokerage firm was, “When E.F. Hutton talks, people listen!”

Federal Reserve Chairman, Ben Bernanke has been trying to have a private conversation with the banking industry for the past year, but a bustling world full of hedge fund managers, proprietary trading desks and other leveraged investors has been listening in.  By acting upon what they overhear whenever Mr. Bernanke whispers a message to the banks, our financial system may be growing more fragile by the day.

The message Mr. Bernanke has been sending to the banks goes something like this: “Borrow short; invest long; pocket the difference.”  Of course, the Chairman of the Federal Reserve cannot speak so bluntly in public, so when he knows the world is listening he chooses his words more creatively, as in, “…economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.” (Source:  FOMC Statement, November 4, 2009)  Either way the message is the same to any investor with access to a line of credit:  “Lifeguard on duty – the water is fine!”

The Fed and the Treasury seem content to remain on duty in the lifeguard tower “for an extended period” out of concern that banks may not find willing buyers for yet another round of outside capital should future losses on commercial real estate and other troubled loans require it.  With sources of outside capital potentially tapped out, the only alternative is inside capital.  In other words, banks must replenish their capital base the old fashioned way – by earning it over time.

In order to earn their way back to health banks need two things from the financial markets – 1) low short-term interest rates to minimize their cost of capital; and 2) stability among higher-yielding securities further out on the yield curve.  The Fed is providing the former with its zero-percent interest rate target for fed funds, while the Fed and Treasury are coordinating to support the latter condition through quantitative easing and the Fed’s purchase of billions worth of longer-dated mortgage backed securities.

It is little wonder that asset markets all over the world jump a few percentage points every time the Fed reiterates its commitment to ultra-low interest rates.  Bernanke and company may be speaking to the banking industry, but the whole world is listening in.  Each time banks get the green light from the Fed to keep swimming for another six weeks, hedge funds and other leveraged investors hear the same message. 

Borrow short – invest long.  The Fed has your back.  Even Citi can make a buck in this environment…while it lasts.

The problem is that ultra-low borrowing costs distort asset values.  An investor with a 1.5% cost of capital can treat valuation as a secondary consideration when he allocates his borrowed money.  Intrinsic value takes a back seat to return spreads and expected volatility. 

If the expected return for an asset is higher than an investor’s cost of capital, and the volatility of the asset is forecast to be moderate, it doesn’t really matter to a leveraged trader what the asset is – Treasury notes, mortgage-backed bonds, junk bonds, commodity futures, emerging market ETFs…take your pick.  The recent emergence of unusual correlations among asset sectors like gold and long-term bonds, or oil and consumer discretionary stocks, provides empirical support for the notion that fundamentals might be taking a back seat to spread and volatility forecasts among many market participants.

Those of us without an Ivy League MBA may be quick to ask, “Isn’t this the same logic that drove us to the edge of the abyss in the first place?”  Unfortunately, the answer is, “yes.” 

Unnatural borrowing costs anchored to a zero-percent Fed Funds rate may be driving many asset markets beyond equilibrium conditions today.  For instance, we are barely six-months removed from the most traumatic financial crisis since the Great Depression, and yet prices for junk bonds have been bid so high that the nominal yield for this asset class is now 200 basis points below its long-term average.  A barrel of oil fetches $77 in an environment of shrinking global demand and bulging inventories.  The price-to-earnings ratio for the U.S. stock market is back to levels typically reserved for the tail-end of a bull market, not a middling economic climate facing the headwind of a global credit contraction.

To the extent that some asset prices may be overshooting their longer-term equilibrium values it probably will not pay to bet against these markets until the feedback mechanism that supports them dissolves.  As long as the Fed maintains its ultra-low interest rate policy and investors remain confident in the stability of longer-dated asset prices the bull market in most markets can continue.

But every great party extracts a price in the form of a hangover.  Today’s party is being hosted by the Fed and the Treasury, whose coordinated effort to recapitalize the banking sector has spiked the punch for any leveraged investor who chooses to drink from the same bowl.  The hangover will follow eventually.  The magnitude of sour stomach and regret investors may endure will depend on how long the party lasts, and how far asset prices drift before the punch bowl goes empty.

 (c) Capital Advisors, Inc.

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